THE COST OF MARKET VERSUS REGULATORY DISCIPLINE IN BANKING

We present evidence that insured deposit financing shields banks from the full costs of market discipline. Moody's downgrades, indicators of increasing risk, are associated with negative abnormal equity returns that are increasing in the bank's reliance on insured deposits. Moreo ver, banks raise their use of insured deposits following increases in risk. These findings cast doubt on the ability of capital market parti cipants to effectively discipline bank behavior within the current reg ulatory environment. More generally, our findings highlight the potent ial for regulation to undermine market discipline in regulated industr ies. (C) 1998 Elsevier Science S.A. All rights reserved.